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Foreign exchange interventions under a one-sided target zone regime and the Swiss franc

Deutsche Bundesbank 2020.06.29
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From September 6, 2011 to January 15, 2015, the Swiss National Bank (SNB) imple- mented a one-sided exchange rate target zone vis-`a-vis the euro, the currency of its most important trading partner. During this episode, the SNB accumulated large foreign ex- change (FX) reserves, which ultimately raised concerns about the balance sheet risks that it was incurring and led to strong political pressure to abandon the minimum exchange rate regime. When the SNB finally abandoned this regime, it argued that it had taken this decision after having compared the costs 2 and benefits 3 of this unconventional mon- etary policy measure. Motivated by this episode, this paper generalizes the structural model proposed by Hertrich (2016a) to determine the expected size of FX interventions under a unilateral one-sided target zone by embedding the model within the Krugman (1991) target zone framework, which has become one of the standard tools in this strand of literature (Rodr´ıguez and Rodr´ıguez, 2007) . At this point, readers may argue that the theoretical predictions of the Krugman model could not be confirmed in earlier empirical studies that analyzed other target zone regimes, but “this time is different!” There is strong empirical evidence indicating that the Krugman (1991) exchange rate target zone model (hereinafter referred to as the “Krugman model” ) is well suited to describe the EUR-CHF exchange rate dynamics in the period of interest. In line with these findings, an empirical application of the proposed model to the aforementioned episode reveals that it is well suited to explain the actual size of these interventions and that, in January 2015, the SNB’s euro purchases might indeed have been large in the short term without the abandonment of the minimum exchange rate regime, which is consistent with the official statements of the SNB in the aftermath of that episode. The advantages of the proposed model are threefold. First, contrary to Hertrich (2016a) , it is assumed that the economic fundamental (and not the exchange rate) follows a reflected geometric Brownian motion (RGBM) , in line with a large body of the target zone literature. By contrast, assuming that the exchange rate follows an RGBM as a first- order approximation may lead to sizable distortions.

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